Arbitrage is an activity of buying and selling of same asset or commodity to earn profit.
Activity results in profit due to buy price remains lower than the sell price.
Arbitrage opportunity in not limited to financial world. It is applied at broader level.
Let’s take a simple example:
A farmer produces rice and sells in local market. The local market price per kg be $ 5. Now
same farmer visits to a market which is about 50 miles away from local market. He
surprisingly finds the rice sold here at $ 6 per kg. Farmers comes back to local market and
purchases 1000 Kgs of rice from other farmers and loads into a truck and sells total
quantity for $6 per kg and earns immediate profit of $1000! and he pays $50 to transporter.
Now net profit for him is $950
The above act of making profit is called arbitrage and risk was negligible. Risk will always
be present but it will be negligible hence called near to risk free profit.
Arbitrage argument:
If price of any security is not equal to a particular determined value then trader can make
riskless profit.
Now let’s see an example for arbitrage argument:
A stock quoted for $1000 for X quantity now the prevailing interest rate 7% and dividend
of 2%. Then future price a year ahead can be calculated as = 1000 x (1+(7%-2%)) = $ 1050
(avoiding continuously compounding expression e or exponential). Now if the given price
is not equal to the calculated price then trader can earn riskless profit either. Say stock is
either at 950 or 1100 then anyone can earn risk free profit either by selling future price of
1050 or buying at 1050 respectively.
This argument is important in financial and economic world because the many price based
decisions are made by financial institutions and has impact economies. The overall